The economic crisis in Argentina has fostered renewed discussion
of dollarization as a policy option for Latin American countries. By
replacing their domestic currencies with the U.S. dollar, countries
considering dollarization hope to achieve economic stability and
growth. However, dollarization does nothing to resolve structural
and institutional problems which, in many cases, give rise to crisis
conditions in the first place. These problems must be addressed in
order for countries to achieve long-term economic stability and
growth. In short, dollarization is not a panacea for what troubles
many Latin American economies.

Why the U.S. dollar? Since the United States is the main
trading partner of most Latin American countries, the U.S. dollar is
used extensively for international transactions. The process of
dollarization in Latin America accelerated after the external debt
crisis, when countries struggled with recession, inflation and
unemployment. After a series of failed stabilization attempts, these
countries faced higher inflation rates, larger fiscal deficits,
deeper external imbalances and continuous capital flight. Under
these circumstances, individuals initially used the dollar as the
hard currency to protect their incomes from the detrimental effects
of inflation. As inflation became chronic, the dollar became the
unit of account for contracts and large denomination transactions.
At the end of the 1980s, it became more common for U.S. currencies
to circulate alongside domestic currency. This process was
encouraged even further when some governments began to allow
deposits and loans in U.S. dollars.

What is the definition of dollarization? Under official or
full dollarization, the U.S. dollar is the legal tender for all
transactions in the economy. Several countries have already
officially dollarized. Panama adopted the U.S. dollar as its
official currency in 1904, Ecuador dollarized in September 2000 and
El Salvador dollarized in January 2001. Unofficial or partial
dollarization, which is widespread in Latin America, refers to the
process where individuals substitute domestic money with foreign
money in order to conduct transactions and protect the purchasing
power of their income. The table shows the degree of dollarization
in several Latin American countries by calculating bank deposits in
foreign currency as a percent of total liquidity. While
dollarization is an observable process, it can only be measured
accurately if financial transactions using foreign currency are
permitted.

Why would a country adopt full dollarization? Countries
initiating full dollarization seek policy credibility. Full
dollarization requires a serious commitment to maintaining
consistent economic policy, and governments must introduce a series
of institutional and structural reforms. In the case of Ecuador,
full dollarization helped to reduce inflation (and expectations of
inflation) and to bring economic stability. In El Salvador, in
contrast, the implementation of full dollarization was part of the
process that included stabilization and structural reforms.
Authorities there expect that full dollarization will promote
foreign investment and integration with international markets.

What are the implications of full dollarization in the short
run? Under full dollarization, the fact that money supply varies
according to the net foreign reserves will have several implications
for economic policy. First of all, the central bank is no longer the
lender of last resort, meaning that it cannot provide funds to
financial institutions in trouble. Its function instead is to
maintain the soundness and efficiency of the financial system.
Second, since the government can no longer print money, it can only
finance fiscal deficits through alternative sources of revenue.
These implications have both costs and benefits. The restrictions on
changing the money supply can improve policy credibility given the
fact that many countries in the region have a long history of
hyperinflation that resulted from printing money to finance fiscal
deficits.

However, if the government wants to counter a recession through
countercyclical spending, economic agents could interpret it as a
signal of a lack of commitment to maintaining a consistent economic
policy. Another cost is the loss of seigniorage, which is the
revenue that the government receives for creating money.
Furthermore, in a fully dollarized economy, interest rates are
expected to decline because there is no depreciation risk. This
would lower the borrowing costs of the private sector and promote
investment. However, this decline could be offset by an increase in
the country risk or default risk. Default risk depends upon the
country’s ability to pay for its debt, principal and services.
Borrowing by issuing government debt is an alternative source of
fiscal financing. Therefore, the government needs to demonstrate a
commitment to fiscal discipline and debt repayment.

By adopting the U.S. dollar, the financial system also opens to
capital flows. Capital mobility promotes financial intermediation,
competition and efficiency among institutions, and helps restore
confidence in the financial system. It also encourages integration
of the financial system with the rest of the world. However, this
openness to international markets also exposes a country to external
shocks, and it can make coping with internal shocks more costly. For
example, in the event of a natural disaster, a dollarized economy
would be more dependent on external resources to finance
reconstruction. Dollarized economies can no longer rely upon
monetary and exchange rates policies to respond to the negative
effects of these shocks on the economy.

Is full dollarization sustainable in the long run? A
dollarized economy will become dependent on a continuous flow of
international reserves or foreign currency and consequently on the
conditions of international markets. In order to maintain
satisfactory economic growth, a fully dollarized country needs to be
competitive internationally and attract capital flows, either as
foreign investment or net borrowing.

The sustainability of a fully dollarized economy will depend upon
how successfully the government implements fiscal discipline,
including tax and expenditure reforms. Improved supervision and
regulation of the financial system can provide stability and promote
confidence that the system can respond to financial crises and
sudden capital outflows. Diversification of exports and the
promotion of competitiveness is also important to encourage
investment and economic growth. Consequently, dollarization does not
stand alone as a remedy for economic maladies. It might buy some
time in the short run; however, it must be accompanied by a series
of structural reforms in order to achieve economic growth and
development in the long term.